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The policy rotation in the US should favor a further appreciation of the US dollar in 2017. This tends to undermine both USD lending to non-US borrowers and international FX reserves, two factors that will probably amplify the dollar scarcity.
On top of that, the Fed outlook for H1’17 is now more uncertain, with risks of a more hawkish tone ahead. All this supports some basis widening, which could accelerate on sizeable EUR offshore issuance in Q1.
In Europe however, expectations of PSPP tapering and higher EUR rates will eventually favour tighter bases. We would therefore consider tighteners in EUR, but vs GBP, on expected further Brexit-led risk aversion.
2016 has seen the EURUSD cross-currency basis reaching its most negative levels since the sovereign crisis. This mostly reflects a greater imbalance in supply/demand for US dollars.
As we note below, the supply of US dollars has been hampered by tighter bank lending and declining international FX reserves in recent years, both on the back of an appreciating currency (USD) and lower oil prices. Demand on the other side has been intense, especially from Japanese banks that face substantial liabilities in USD terms.
Liquidity has also become an ever-greater issue. Banking regulations have made balance sheet expansion very costly for banks. As a result, market participants are no longer able to fade the arbitrage induced by the loss of covered interest parity in bases. This is a radical change in comparison to the pre-2008 world.
Reduced liquidity, as a consequence of the more recent regulations, is set to leave the basis ‘open’ at negative levels in the long run.
Recommendations:
Turn on receivers in 2Y2Y EURUSD versus payers in 2Y @ 4bp. Target -11bp. Stops 13bp.
Turn on receivers in 5Y5Y GBPEUR @ 36.5bp. Target 18bp. Stops 46bp.
